On his last day as RBI Governor, Raghuram Rajan spoke to students of St Stephen’s College on the importance of an independent central bank. He drew their attention especially to the issue of the RBI’s dividend, or the surplus it generates, because “it is your money”.

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One of the issues in the current public tussle between the RBI and the government concerns the transfer of the Bank’s dividend to its sole shareholder. In his speech, delivered on September 3, 2016, Rajan underlined that the RBI under him had made the largest ever dividend payouts to the government — 99.99% of its surplus in 2013-14, 2014-15 and 2015-16 — and yet there were suggestions that the Bank could do still more. These suggestions, he said, reflected an inadequate understanding of the way a central bank’s balance sheet works.

Rajan explained this: “We print currency… as well as issue deposits (or reserves) to commercial banks. Those are our fixed liabilities…We buy financial assets from the market. We do not pay interest on our liabilities. However, the financial assets we hold, typically domestic and foreign govt bonds, do pay interest. So we generate a large net interest income simply because we pay nothing on virtually all our liabilities. Our total costs… amount to only about 1/7th of our total net interest income. So we earn a large surplus profit, more than all the public sector put together, because of the RBI’s role as the manager of the country’s currency. This belongs entirely to the country’s citizens. …After setting aside what is needed to be retained as equity capital to maintain the creditworthiness of the RBI, the RBI board pays out the remaining surplus to the RBI’s owner — the government.”

After the RBI’s risk analysis showed that its equity position of around Rs 10 lakh crore was adequate, the Bank’s board decided to transfer its entire surplus to the government (peaking at Rs 65,876 crore for 2015-16, which accrued to the Centre in the following fiscal), Rajan said. “Yet some suggest we should pay more, a special dividend over and above the surplus we generate. Even if it were legally possible to pay unrealised surplus — it is not — and even if the board were convinced a higher dividend would not compromise the creditworthiness of the RBI, there is a more fundamental economic reason why a special dividend would not help the government with its budgetary constraints.”

So what is the problem with being generous?

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Rajan explained that much of the RBI’s surplus comes from interest on government assets or from capital gains it makes off other market participants. In paying this to the government as dividend, the RBI is putting back into the system the money it has made from it — there is no extra money-printing involved. However, to pay an additional dividend to the government, the RBI has to create additional permanent reserves, i.e., print more money. “Every year, we have in mind a growth rate of permanent reserves consistent with the economy’s cash needs and our inflation goals,” Rajan said. “Given that budgeted growth rate, to accommodate the special dividend we will have to withdraw an equivalent amount of money from the public by selling government bonds in our portfolio, or alternatively, doing fewer open market purchases than we budgeted.”

There were no “creative ways of extracting more money from the RBI”, Rajan said. “…The government should acknowledge its substantial equity position in the RBI and subtract it from its outstanding debt when it announces its net debt position… We have been tasked with the job of maintaining macroeconomic stability, and often that task requires us to refuse seemingly obvious and attractive proposals… That is why the country needs a trusted independent central bank.”

What is the view on the government’s side?

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Rajan’s predecessor Duvvuri Subbarao, who was Finance Secretary before he became Governor, has written that central banks are apprehensive of threats to their balance sheets because (i) despite having the ability to discharge their financial obligations by creating money, sustained losses can weaken their ability to conduct policy effectively and, (ii) mounting losses can compel them to approach the government for capital infusion, which they want to avoid in order to preserve their independence. The quantum of surplus transfer has, however, not been a major factor in defining the central bank’s relationship with the government — “a settlement is reached with both sides showing some flexibility”, Subbarao has written. This is why the recent acrimony has appeared worrisome to many.

Two years ago, then Chief Economic Advisor Arvind Subramanian flagged the issue of surplus profits and capital in the annual Economic Survey. Like now, the Finance Ministry has earlier, too, felt that the building up of buffers such as the Contigency Fund and Asset Reserve by the RBI — which began under Governor C Rangarajan and his Deputy S S Tarapore — has been far in excess of what is required to maintain creditworthiness.

Almost all central banks are owned by their national governments, and have to transfer surpluses or profits to the Treasury. The UK has a formal Memorandum of Understanding on the financial relationship between the Treasury and the Bank of England. The entire net profits are passed to the government. The MoU is formally reviewed at least every five years, and there is a provision for an intermediate review in the event of changes to the risk environment.

In the United States, too, the Federal Reserve transfers all its net earnings to the Treasury. Three years ago, the Fixing America’s Surface Transportation (FAST) Act made it mandatory for the Fed to transfer part of its surplus to the Treasury to fund spending on highways, drawing criticism from former Fed Chair Ben Bernanke, who described it as a budgetary sleight of hand.

How does the relationship framework work in India?

In his September 2016 speech, Rajan said the risk management framework adopted by the RBI board indicates the level of equity the RBI needs, given the risks it faces. The dividend policy then becomes a technical matter of how much residual surplus is available each year after bolstering equity. “Frameworks reduce the space for differences. Clarity would be useful on when RBI should issue a warning on fiscal profligacy rather than be seen as interfering in the legitimate decisions of elected representatives…,” he said.

The Indian economy is now too big and complex for the RBI to remain a “subordinate office”, as a former Finance Minister had described it. There is a reason central bank Governors sit along with Finance Ministers at the G20, Rajan had said: the Governor, unlike government Secretaries, “has command over significant policy levers and has to occasionally disagree with the most powerful people in the country”.

So, what is the best way forward here on?

Former Governor Y V Reddy said in a public lecture that RBI’s autonomy vis-à-vis the Finance Ministry is more de facto than de jure, and that “de facto autonomy is possible only when the central government… reposes confidence and trust in the RBI”. The RBI’s longer-term view of macroeconomic management ensures an intrinsically varying perspective with the government, Reddy said. However, “If a central bank always concurs with the government, it becomes superfluous, while if it persists with constant disagreements, it becomes obnoxious.”

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In 2016, there was no major uproar in Germany after the Bundesbank’s surplus fell significantly short of Budget projections. Presumably, this was because the German federal government was running a surplus budget. During the high-growth years of 2004-05 to 2008-09, voices in India demanding higher surplus transfers to the government remained muted. Aggression in demands indicates that the government’s fiscal position is under pressure. In the context of the noise over the government using Section 7 of the RBI Act as the first step before issuing a directive to the RBI, it is helpful to remember that the previous government had come close to issuing a similar diktat to securities markets regulator Sebi — and that the situation had been defused by cool heads in New Delhi.